Wednesday, October 29, 2008
bank triage and the flaws of semi-nationalization
Treasury is focusing its equity infusion efforts on strong banks, leaving the rest to find their own exit strategy.
But this approach is not surprise; in fact, it is exactly what Treasury said it would do in a conference call to analysts exactly a month ago.
and that is bad news for the weakest banks, many more of which figure to either be taken under -- such as PNC bank did national city recently -- or fail.
some form of triage is very necessary here -- banking needs badly to delever and downsize as the credit bubble unwinds, and treasury will waste resources trying to save most banks in their current configuration. many must fail. however, yves makes an excellent point about promoting aggregation.
In theory, this might not be a bad idea. The banking industry needs to be rationalized, since excessive leverage permitted the entire industry to grow well beyond sustainable levels. In 1980, financial firms accounted for 8% of S&P 500 earnings. At the industry's peak, they were 46% of S&P earnings.
However, the way the Treasury is going about this assures that big firms will become even larger. That is not a plus for systemic stability. The only thing worse than firms to big to fail is firms too big to rescue.
more from the guardian. confirming opinion is available at the institutional risk analyst.
Last week, we had a conversation with Josh Rosner about precisely this prospect, namely were the Treasury eventually to take control of JPM, C and BAC, would not the better public policy choice be breaking up these giant banks to help recapitalize, re-liquefy and grow the smaller, healthier survivors? There would still be a large concentration of deposits among the top 100 banks by assets, but the distribution would be more even than today.
Instead of trying to orchestrate mergers of weak regional banks, as Paulson is reported to be pursuing, perhaps instead the Treasury should ponder some creative destruction as and when further equity infusions are required. Such is the magnitude of the peak loss wave approaching the banking industry, in our view, that considering how to resolve fully nationalized money center banks to best recapitalize the industry seems appropriate.
this stems from a desire on the part of treasury to avoid (at least for the time being) the more direct but painful route to banking recapitalization -- nationalization.
the "semi-nationalization" plan of capital injections in exchange for warrants or preferred has two primary flaws: 1) participating banks -- having written down assets not even to the extent that jeopardize capital ratios, much less reflect reality -- will be sitting on capital injections as loan loss reserves for the next several quarters hoping to ride out the storm; 2) participating banks will take capital injections as fuel for acquisitions -- either of well-capitalized smaller banks or of deposit bases out of FDIC receivership -- in an effort to strengthen by preying on the non-participants. (thus far, marshall & ilsley is a non-participant.)
the former is apparently befuddling the easily-befuddled bush administration -- see idiotic white house comments here. expanding lending into a severe contraction is suicidal for banks, particularly when it is already obvious that asset values already on the books will be suffering. nationalization could have addressed this -- by taking over banks entirely, government might have stepped in to force asset writedowns to "nuclear winter" levels and then recapitalized (including forced debt-to-equity conversions to reduce government expenditure) the de-risked banks with a hope toward actually having them lend. but of course that path is economically difficult and (need one say) hits hardest the elite republican constituency -- the predator class. as paul kedrosky pointed out, however, it is still going to happen anyway.
the latter, as noted by the IRA, would also have a solution in nationalization -- and may yet, as the synthetic CDO bomb detonates over the money center banks. but the aggregation of banks into larger banks, despite being a natural result or market forces here, is not helpful. in the short term, a deeply-troubled outfit like huntington bancshares -- one of the participants -- or a very thinly-capitalized PNC may well tie up healthier smaller banks to improve their aggregate condition with the effect of removing the lending power of their targets from the market rather than liquidating their bad assets. this would reduce bank lending, not expand it. and in the long term, there are questions of the desirability of big banks. perhaps the best possible outcome of the bust would be the return of banking to a facilitating role, with a network of stable smaller entities giving the system greater redundancy and flexibility -- much like a utility -- rather than any attempt to return to the center of western economies. that result is most directly achievable first through nationalization, then reprivatizing under a far more comprehensive and powerful regulatory scheme.
here again, however, the path to better functionality is the more painful one, particularly for the predator class -- and it is hard to expect the party that more directly represents their interests to take that path for the benefit of the broader society when they haven't given a damn about broader society except to exploit it from the get-go. i'm left to reaffirm by view that what conservatives should most hope for is a rehabilitation of the republican party by virtue of casting it into the political wilderness for a decade or more.